Introduction

The elasticity of Fed money was not the only issue of interest in the decade following World War I. An issue of equal importance was whether reserve banks' use of their individual money production powers, now that they no longer faced a 100 percent gold reserve nor were shackled by a wartime financing policy, would result in an over issue of money. In addressing the over issue problem, Federal Reserve historians, such as Chandler (1958), Friedman and Schwartz (1963), and Wheelock (1991), have recognized the special attributes of the early 1920s environment. They have tended to view the period from 1921 to 1923 as one of profit-seeking reserve banks actively competing with each other. In the words of Friedman and Schwartz, “open market operations were not yet coordinated but were being carried out primarily to increase earnings rather than as general credit policy” (1963, pp. 281–2).

Conventional wisdom holds that competitive reserve banks would be prone to over issue money. Speaking with specific reference to the early 1920s, D'Arista pointed to the likelihood that reserve banks would tend to “create easy money” (D'Arista, 1994, p. 74). In a more general context, Rolnick, Smith, and Weber (1993, 1994) have given the tendency of over issue by competitive money producers the generic label of a “seigniorage incentive problem” (Rolnick, Smith, and Weber, 1993, 1994).

The conventional wisdom can be contrasted with the microeconomics perspective presented in chapter 2. That model emphasized the market constraints on over issue. Simply put, competition in the reserve bank industry would be associated with monetary restraint and the absence of a seigniorage incentive problem.